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Month: August 2009

Independent Contractor (Self-Employed) or Employee?

It is critical that you, the business owner, correctly determine whether the individuals providing services for your company are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.

If you are an independent contractor and hire or subcontract work to others, you will want to review the information in this section to determine whether individuals you hire are independent contractors (subcontractors) or employees.

Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be –

People such as lawyers, contractors, subcontractors and auctioneers who follow an independent trade, business, or profession in which they offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case.

The general rule is that an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.

If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (statutory employees) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social Security and Medicare taxes, below.

A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.

A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.

An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.

A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for you must be the salesperson’s principal business activity.

There are generally two categories of statutory nonemployees: direct sellers and licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:

Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and

Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.

In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

Common Law Rules

Facts that provide evidence of the degree of control and independence fall into three categories:

1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done – as long as the employer has the right to direct and control the work.

The behavioral control factors fall into the categories of:

Type of instructions given

Degree of instruction

Evaluation systems

Training

Types of Instructions Given

An employee is generally subject to the business’s instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work.

When and where to do the work.

What tools or equipment to use.

What workers to hire or to assist with the work.

Where to purchase supplies and services.

What work must be performed by a specified individual.

What order or sequence to follow when performing the work.

Degree of Instruction

Degree of Instruction means that the more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.

Note: The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.

Evaluation System

If an evaluation system measures the details of how the work is performed, then these factors would point to an employee.

If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee.

Training

If the business provides the worker with training on how to do the job, this indicates that the business wants the job done in a particular way. This is strong evidence that the worker is an employee. Periodic or on-going training about procedures and methods is even stronger evidence of an employer-employee relationship. However, independent contractors ordinarily use their own methods.

2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job.

The financial control factors fall into the categories of:

Significant investment

Unreimbursed expenses

Opportunity for profit or loss

Services available to the market

Method of payment

Significant investment

An independent contractor often has a significant investment in the equipment he or she uses in working for someone else. However, in many occupations, such as construction, workers spend thousands of dollars on the tools and equipment they use and are still considered to be employees. There are no precise dollar limits that must be met in order to have a significant investment. Furthermore, a significant investment is not necessary for independent contractor status as some types of work simply do not require large expenditures.

Unreimbursed expenses

Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.

Opportunity for profit or loss

The opportunity to make a profit or loss is another important factor. If a worker has a significant investment in the tools and equipment used and if the worker has unreimbursed expenses, the worker has a greater opportunity to lose money (i.e., their expenses will exceed their income from the work). Having the possibility of incurring a loss indicates that the worker is an independent contractor.

Services available to the market

An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

Method of payment

An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.

3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Type of relationship refers to facts that show how the worker and business perceive their relationship to each other.

The factors, for the type of relationship between two parties, generally fall into the categories of:

Written contracts

Employee benefits

Permanency of the relationship

Services provided as key activity of the business

Written Contracts

Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker’s status. The IRS is not required to follow a contract stating that the worker is an independent contractor, responsible for paying his or her own self employment tax. How the parties work together determines whether the worker is an employee or an independent contractor.

Employee Benefits

Employee benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors. However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.

Permanency of the Relationship

If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.

Services Provided as Key Activity of the Business

If a worker provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

You can learn more about the critical determination of a worker’s status as an Independent Contractor or Employee at IRS.gov by selecting the Small Business link.

Additional resources include IRS Publication 15-A, Employer’s Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS Web site or by calling the IRS at 800-829-3676 (800-TAX-FORM).

Trade-Offs In A Roth IRA Conversion

Deciding whether to convert a traditional IRA to a Roth IRA involves trade-offs. If you convert, you pay tax much sooner than you need to. But conversion can cut your overall tax on your retirement account.

People whose modified adjusted gross income (MAGI) in 2009 will be $100,000 or less face a second decision. If you convert, should you do it now or wait until 2010? In 2010 a unique but temporary tax break will be available: Roth IRA conversions will be available to taxpayers regardless of Modified Adjusted Gross income, and the taxable income can be divided evenly between 2011 and 2012 returns.

Even if your MAGI is over $100,000 this year, you may need to know the choices so you can advise lower-income children or parents.

First, is a Roth IRA conversion desirable?

You’ll owe income tax on all the untaxed money in the traditional IRA you’re converting. After conversion, all Roth IRA withdrawals can be tax-free. (after five years and after you’re age 591/2).

You’ll never have to take required minimum distributions. RMDs are generally required from a traditional IRA once you hit age 701/2.

In the past, Roth IRA conversions were available only to taxpayers with MAGI of $100,000 or less. That cap will be removed in January. In 2010 anyone with a traditional IRA can convert to a Roth IRA — the first chance for many high-income taxpayers to own a Roth. High income taxpayers generally have been barred from starting Roth IRAs from scratch, too. Eligibility for contributions to a Roth in 2009 phases out for a single taxpayer with MAGI of $105,000 to $120,000. For marrieds filing jointly, phaseout is $166,000- $176,000.

To encourage Roth conversions in 2010 and boost tax collections, Congress created a one-year tax break.

Typically, the income tax from a Roth IRA conversion is due for the year of the conversion. For Roth IRA conversions in 2010 the resulting income can be divided evenly between your 2011 and 2012 tax returns.

Tax Tactic

Say a hypothetical Jim Wilson converts a $300,000 traditional IRA to a Roth IRA in 2010.

So Wilson has $300,000 of taxable income from the conversion. He can report that $300,000 on his 2010 tax return.

Or Wilson can report nothing for 2010. If so, he’ll report $150,000 of that income on his 2011 return. Then he’ll report the other $150,000 on his 2012 tax return.

That brings up the second decision, which faces taxpayers with MAGI of $100,000 or less this year. If you’d like to do a Roth conversion, should you do it now or in January 2010?

The case for doing it now.

Despite the recent rally, many IRA balances are still depressed. The less you have in your IRA, the less tax you’ll owe on a conversion. After a Roth IRA conversion, any subsequent appreciation can be tax-free. But from today’s low levels, it’s likely that a recovering stock market will drive IRA values higher. So the sooner you convert, the less money that’s likely to be hit by tax.

If you don’t convert until 2010, you may owe more tax on a larger IRA. Market rallies can be fast. The S&P 500 was already up 48% off its March 6 low, going into Friday (7/31/09).

And what if Congress hikes tax rates? If you wait until 2010 to convert, planning to defer the taxable income until 2011 and 2012, you might owe tax at higher rates.

What’s more, converting any time in 2009 starts the five-year clock for tax-free withdrawals back at Jan. 1 of this year.

The case for waiting.

By waiting a few months, you’ll lock in years of tax deferral.

If you convert in January 2010, you can start to enjoy tax-free appreciation right away. Yet you’ll get two and three years of tax deferral because you can delay the final tax payment until 2013, when you file your 2012 return.

Given those choices, how should you proceed? “If a Roth IRA conversion seems attractive now, do it,” said attorney Natalie Choate, with Boston’s Nutter McClennen & Fish.

And if a 2009 Roth IRA conversion turns out to be a faulty move, you can change your mind. A conversion this year can be recharacterized — as the IRS calls a reversal — until Oct. 15, 2010.

Suppose Jim Wilson converts his $300,000 IRA to a Roth in 2009. Let’s say that by October 2010 stocks have soared, and the Roth IRA is worth $400,000. Wilson can leave his Roth IRA in place, with $100,000 of tax-free gains.

But suppose stocks plunge, and Wilson’s IRA falls to $200,000. By Oct. 15, 2010, he can tell his IRA custodian he wants to recharacterize.

After filing an amended return, Wilson will get back any tax he paid on the 2009 conversion. He’ll have a $200,000 traditional IRA.

If he wishes, after waiting 31 days Wilson can convert that $200,000 traditional IRA to a Roth IRA in late 2010. He’ll owe less tax than he owed on the 2009 conversion because of the smaller account size and he’ll be able to defer the tax obligation until 2011 and 2012.

2010 Roth IRA Conversions

Back in May of 2006 there was a pretty significant change to the tax laws involving converting a traditional IRA to a Roth IRA. In the year 2010 everyone can convert their traditional IRAs to a Roth IRA – and that’s an opportunity that not everyone had in the past.

In this article we’re going to talk about the Roth IRA conversion rule change that goes into effect in 2010. We’re also run through some of the strategies that individuals can use to take advantage of this change, starting today.

Roth IRA Conversion Rules

Under the current tax law for Roth IRA conversions – which was written in 1997 – individuals were permitted to convert a traditional IRA to a Roth IRA. There were only two stipulations that taxpayers had to worry about – paying taxes on the converted money and an income limit which determined eligibility to convert.

Converting an IRA to a Roth

With a traditional IRA money can be placed into the account on a pre-tax (tax deductible) and after-tax basis. That investment is allowed to grow on a tax-deferred basis until withdrawn in retirement.

If an individual wanted to convert a traditional IRA to a Roth IRA they had to pay federal income taxes on any pre-tax contributions as well as any growth in the investment’s value. After all, once converted to a Roth, all of the investment could now be withdrawn on a tax-free basis in retirement.

Income Limits on Conversions

Unfortunately, that same 1997 tax law also contained a provision limiting who could make a conversion. Upper income taxpayers – those with adjusted gross incomes of more than $100,000 – whether single or married were not eligible to make such a conversion.

In addition, if you earned $110,000 or more ($160,000 for married joint filers) then you also weren’t eligible to contribute to a Roth IRA. These two tax laws effectively precluded upper income taxpayers from enjoying the benefits of a Roth IRA. They couldn’t convert their traditional IRA to a Roth, and they could fund one either.

IRA Conversions in 2010

But back in May of 2006 President Bush signed a $70 billion tax cut provision that changed the eligibility rules for Roth IRA conversions. Starting in 2010, taxpayers with modified adjusted gross income of more than $100,000 will be allowed to convert a traditional IRA to a Roth IRA. This change applies to all years beyond 2010 – and the income taxes due on the 2010 conversion can be spread over two years. So the 2010 conversion amount may be included as taxable income in 2011 and 2012 – helping to spread out the tax bite. Conversions in subsequent years are included in income during the tax year in which the conversion is completed.

Removing the Roth IRA conversion cap however doesn’t mean anyone can fund a Roth IRA, but it does mean that anyone can convert an existing IRA to a Roth IRA.

Taking Advantage of the 2010 Rule

Fortunately there is a way for all taxpayers – regardless of income – to take advantage of this change in the tax code:

Start Funding a Traditional IRA Right Now!

Even if you don’t qualify to make Roth IRA contributions or traditional IRA contributions on a before-tax basis, you can still make after-tax contributions to a traditional IRA. If you invest in a non-deductible IRA in the tax years 2006 through 2010, then you can convert those IRAs to Roth IRAs in 2010.

Most investors shy away from making non-deductible contributions to an IRA because they are not tax deductible, the investment growth is fully taxable, and because they are subject to minimum distribution rules they offer only a minimal tax shelter. But by converting these non-deductible IRAs to Roth IRAs in 2010 many of those disadvantages disappear.

Roth IRA Conversion Examples

There is one important rule to keep in mind when it comes to converting a traditional IRA to a Roth IRA – you need to pay federal income taxes on any portion of the conversion that you haven’t already paid taxes on.

Example 1

For example, let’s say you started to fund traditional IRAs in 2006 and by 2010 you’ve got $20,000 in your account. Furthermore, let’s say this account consisted of four years of $4,000 non-deductible contributions – a total of $16,000 in non-deductible contributions and $4,000 in account growth.

In this example, you’d need to pay income taxes on the $4,000 in fund growth when you convert to a Roth IRA. But the good news is you’ll never have to pay income taxes on this account again.

Example 2

In this second example, let’s assume that you funded the that same traditional IRA with before-tax dollars – meaning you were able to take a deduction on your tax return for the money placed in the traditional IRA.

In this example, you haven’t paid income taxes on any of the money in the account, so when you convert it to a Roth IRA taxes are owed on the entire account balance. In this case you’d have to pay income taxes on all $20,000 in your fund.

Example 3

If you have an existing traditional IRA (with tax-deductible contributions) and you start to fund a non-deductible IRA, then you need to be aware that tax rules state that any conversion is done on a pro-rata basis. Let’s say you had $100,000 in a regular IRA and you had $25,000 in a non-deductible IRA.

If you wanted to convert $25,000 to a Roth, then you’d owe taxes on $20,000 because the pro-rata share of your non-deductible contributions is only $5,000.

Deciding to Fund a Roth IRA

While it might be very exciting for some individuals to learn that they can use this 2010 law to convert an IRA to a Roth IRA, it’s important to mention that Roth IRAs are not for everyone. Before converting you might want to read our article dedicated to explaining the differences between a Roth IRA and a Traditional IRA. You might also want to run through some what-if scenarios using our Roth versus Traditional IRA calculator. http://www.money-zine.com/Calculators/Retirement-Calculators/Roth-vs.-Traditional-IRA-Funds-Calculator/

It’s always best to make an informed decision and if you ever have a question about what’s right in your particular situation it might be a good idea to consult with a tax professional before deciding if taking advantage of the rule change in 2010 is right for you.